Carbon Emission Policy Set for New Debate

The choice of carbon reduction policy is set to rear its head again now that the Australian election is over. Having talked about "the carbon tax" for three years, Prime Minister Abbott now has to frame legislation that will be acceptable to either the current Senate members or the motley crew that seems set to populate the red leather seats of the upper chamber from next July.

Supposedly, the majority of Australia's parliamentarians are agreed on the need to reduce Australia's carbon emissions by 5% before 2020. While the objective might be agreed, the solutions are too frequently unconvincing for any single policy to have been heartily embraced and there has never been more furious debate about an agreed position. This is true not just in Australia.

Among those who most aggressively favour action against climate change, an emission trading scheme is the most popular alternative. This combination of carrot and stick is also the model most favoured by economists. It is the most analytically elegant solution to the problem. In paying a price for their carbon emissions companies can continue to emit but must pay to do so by buying emission rights.

This, the scheme's proponents argue, puts the market in charge although governments have to determine who has to buy permits, who is granted free permits and in what quantities making the idea that this is a pure market based policy something of a myth. In reality, it is regulation dressed up to avoid looking like regulation to appeal to those who would generally oppose more business regulation on principle.

There is also no guarantee that an emissions trading scheme will have the desired effect. The price of permits can fall, as in any market, if there is an imbalance between demand and supply. Governments issuing large volumes of permits, for example, could deflate the price. Weak industrial activity, as in Europe since the financial crisis, would also keep the price low.

There is a chance the price of permits might simply not be high enough between now and 2020 to effect sufficient change.

Australia's Treasury is forecasting a rise in the price of permits in the European market to which Australia is aligned. There is no reason to believe that its forecasts for this price will be more accurate than its forecasts of prices in any other international commodity market.

An emission trading system also risks instability. A recovery in Europe combined with a shortage of permits as other governments fail to join could result in a very high price that imposes such a burden on companies as to create unsustainable (or politically unacceptable) costs.

Fluctuations in the price of carbon could have the same negative effects on the profitability and investment of key industries as iron ore prices have on steel producers.

A tax on carbon emissions declares more clearly than a trading scheme the need to eliminate a problem and is more certain in its effect. A tax can be raised repeatedly and by enough to eliminate the undesired behaviour. The trap for governments is the temptation to misuse the revenue because, by definition, receipts from the tax will cease to flow if the policy is successful and companies no longer emit excessive amounts of carbon.

In the Australian context, the effectiveness of the tax option is also limited by the abundance of cheap fossil fuels available to local industry. A tax would have to be very high, risking national competitiveness, to force companies to switch to alternative fuel sources. If companies are able to pass on the effect of the tax so as to minimise the impact on their profitability, it could also prove ineffective while significantly eroding consumer spending power.

The reverse of a tax - a subsidy - could deliver more certainty. Of course, someone has to pay the subsidy. Its size would be a clear fiscal burden limiting how aggressively governments could use this tool to achieve its ends. Nonetheless, a government might be better able to secure commitments to reduce emissions in exchange for the payment of a clearly defined amount. A government could exercise discretion about where payments are made to maximise their impact. This edges closer to the model the new government has been proposing.

Outright regulation seems to have been largely discarded as an option despite being effectively used for decades to direct business outcomes in other areas. In the USA, where legislators have little appetite for new laws against carbon emissions, the administration has invoked anti pollution laws. By defining carbon emissions as a form of pollution, the government is simply able to call on existing legislation to tell a business to stop. If the business does not desist, the owners or managers can be fined or sent to jail.

A simple regulatory approach lacks the analytical elegance of an emissions trading system but is entirely consistent with the punitive powers governments in liberal democracies exercise in controlling behaviour from disposal of other forms of waste to speeding on the highway or to murder.

The champions of emission trading sometimes fail to acknowledge that changes in relative prices make the difference not simply putting a price on carbon. As a simple matter of logic, the same effect could be achieved by reducing the price of non fossil fuels, for example, as increasing the cost of using fossil fuels.

Technological advances are needed to reduce the costs of non carbon alternatives. The benefits of innovation tend to flow very rapidly once technology advances past critical points. This is the ultimate use of the market. Technical advances create profit incentives which drive investment.

Prior to that point, there are few, even among the most knowledgeable, who would anticipate the subsequent magnitude of the change. Alexander Graham Bell reputedly declared that one day every town in the USA would have a telephone. A pre iPad era is now unthinkable despite virtually zero penetration for computer tablets only five years ago.

Here, then, is the policy question for the parliamentarians who will be mulling these matters anew in coming months. If Australia is going to use one billion dollars, say, to achieve a reduction in carbon emissions, would that most effectively be used buying emissions permits in Europe, imposing a tax with a widespread incidence, threatening forced closures of power utilities if changes did not occur, offering direct subsidies for less emissions or funding more research and development?

In truth, we do not know. Policy in this area is a giant experiment. However, history says that the effectiveness of research is the area least likely to be appreciated but the most critical if permanent changes in relative prices are to be achieved.

The most zealous advocates of action are likely to want action now rather than trust to the result of research. Despite the uncertainty about the results of research spending, there should be some onus on the advocates of taxes, trading systems and other measures to show that they offer superior returns to a heavier emphasis on research and innovation.

Interestingly, the level of emissions in advanced economies has been falling. In part, this has been due to a slowing in rates of economic activity but the outcomes have gone beyond that. There is some evidence that business is converting to cleaner forms of production simply because innovation is occurring and because they believe it is the right thing to do.

Some economists might argue that the only way to change behaviour is to offer the right price signals but there is also ample evidence of moral values playing a role in how business conducts itself and what consumers choose to buy.

If there was no difference in performance or costs between using a zero emission motor vehicle and a petrol engine, people might willingly opt for the former simply because it was the right thing to do. Moral suasion can play a role in outcomes if the technology has been proven.

(John Robertson is a director of E.I.M. Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, corporate business strategist and investment market professional for over 30 years after starting his career as a federal treasury economist in Canberra. His daily Market Diary - Brief Thoughts on Current Issues is available at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).

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